Forum Archive Index - October 2002

["Lyall W Taylor" <lyall.taylor@lycos.com>]

QUOTE:
"3/ I think, Dimebag, that you do not fully understand the concept of 
Warren Buffett type investing.   You have certainly adopted some of 
the principles of Buffett, but there seem to be others you have 
ignored like:

3a/ Buffett looks for business that generate lots of cash:

As 'Happy' on the other channel put it
--------
"CLI is simply not getting enough cash today to pay its future 
requirements. Its borrowing costs have doubled in the last 12 months 
and interest rates are at record lows and property prices record 
highs. Shareholder funds are only around $1 Bn and total borrowings 
$3.4 bn and this relationship will only get worse until property 
sales occur at the prices (currently at very high levels) CLI has 
predicted to go even higher."

"For each of the next three years CLI  has to keep borrowing around 
$200m pa to meet its requirements."
-------

CLI is chewing up cash, and it has high debt levels!   This alone 
would be enough to turn Warren right off this share."
END QUOTE

Buffett's most fundamental investment principle is that successful investment 
is about determining a company's intrinsic business value, and buying it 
cheaper.

He defines intrinsic value as the cash a company will generate between now and 
judgment day, discounted back to present value.

Now the fact that the company does not generate any free cash flow for many 
years means nothing.  Its what the company will generate in the totality of its 
existance that is critical.

Generally speaking, the high cashflow principle applies, but with investment 
there are no hard and fast mechanical rules.  Different investments vary in 
nature and require different approaches.  Where CLI is unique is that they 
don't need cash to grow.  Writing annuity contracts does not require an upfront 
investment.  Yet they are adding present value - enormous cash will flow in 
time. 

What is important is the present value of future cash flows.

(Its also useful to note that CLI had approximately $1.50 per share in 
operating cash flow in the 2002 year, and cash reserves grew  Cash on hand at 
balance day was in excess of $200m.) 

Secondly, Happy's comments, and your subsequent citation, are misconstrued.  I 
tryed to highlight this in my initial post on this cite.

CLI ARE NOT chewing up any cash.  They should be cash flow neutral on an 
operating basis.  This is the entire essence of their business model - to match 
rental streams with annuity and interest obligations dollar for dollar.  The 
residual value at expiry accrues to CLI.

In our example, the $280,000 in property could be used for the following:

1)  Sell, retire debt of $100,000, and pay a $180,000 dividend (how about that 
for cash flow).
2)  Retain the property, and generate rent ($24,000) less interest ($7,000) = 
$16,000 annual taxable cash flow for shareholders on an ongoing basis, or
3) (the most likely), use the property to support a new, $160,000 annuity, and 
payout $160,000 in CASH to shareholders.

QUOTE
3b/ Warren looks for businesses he can easily understand.  It is true 
that CLI has been going for 5 years, but it is also true that it is 
yet to roll over any of its annuities.   I'm not saying this business 
model is unworkable ( it may work very well ) but it is unproven.  

It is true that CLI may never have to sell their buildings in 
practice, but in 15 years time if new people taking out new annuities 
are to have confidence in CLI they will need to know that those 
buildings *could* be sold (which is the same thing) at the book 
price.  It also appears that the lengths of the property leases are 
less than the typical annuity they service, which means that at the 
end of the lease term the building could be vacant and have crashed 
in value.  
QUOTE END


CLI's business model is easy to understand.  They buy property to match their 
cashflows, and retain the residual equity.  The business model is working very 
well and their is absolutely no reason to think it won't in the future.

All cashflows (rents etc) are legal fixed.  They can't change (except rents can 
rise).  As I illustrated in my initial post, whether CLI's property appreciates 
or not is irrelevent - at current valuations you will still make a forturne.  
CLI's property is top quality - there will always be a ready market for it; 
most of the tenants will roll over; those that don't will have a replacement 
quickly found.  Their rental cashflows rise yearly so its difficult to imagine 
property values collapsing over 15 year time periods.  This would be absolutely 
unprecedented.  Rediculous pessimism, and much of the risk is accounted for in 
the high discount rates anyway.

QUOTE
3c/ At one point you do a rate of return calculation based on the 
then current share price of $2.66 and the $8.00 residual property 
value, calculating an internal rate of return:

$2.66(1+i)^15=$8.00 => i= 7.61%

You should be aware that 7.61% is *way too low* for Warren.  He looks 
for around twice that rate of return.  Note that the rest of the CLI 
business is currently losing money so can't be used to boost this 
return.
END QUOTE


This is the return holders will get out of the EXISTING asset base.  ie if CLI 
stopped doing business today.  CLI are adding new assets to this base yearly.  
Their going concern value is enormouns and overall returns will far exeed 7.61%.


QUOTE
3d/ Buffett looks for a business that has a strong market position, 
but it would seem that CLI is a minnow.   What is to stop one of the 
big UK insurers doing exactly what CLI is doing and snatching away 
any competitive advantage?
END QUOTE

CLI have a 33% market share in Australia.  They have gone from nothing to 
market leading in just 4 years because they have a superior business model that 
gives them a very strong competitive advantage.  They can offer the highest 
annuity return with the least risk.  Other life business back their obligations 
with equities and fixed interest; much riskier with reliance on asset sales to 
meet obligations.  Returns are lower.

CLI was also first to market, now has a strong brand, is well managed, 
innovative, and will remain competitively superior.


QUOTE
I think you are seeing this blue chip property that CLI is investing 
in as a clutch of golden eggs, while failing to fully appreciate the 
risk of them being carried in the paper basket that is CLI itself.
END QUOTE

With respect, I think you and many others are grossly overstating the risks due 
to poor fundamental understanding of their model.  CLI are VERY LOW RISK at 
current prices, offering a very high return.

Also with respect, I think this is precisely the type of stock Buffett would 
buy.

Regard
Dimebag


PS Phaedrus

The above highlights just how subjective fundamental analysis is.  The 
consensus fundamental opinion IS NOT my opinion.  I am the contrarian, and 
their fundamental have not been a screaming buy to all investors.

Fear, confusion, misunderstanding and misinformation appear to be the drivers 
of the current price. 


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